Discussion paper

DP4654 Optimal Operational Monetary Policy in the Christiano-Eichenbaum-Evans Model of the US Business Cycle

This Paper identifies optimal interest-rate rules within a rich, dynamic, general equilibrium model that has been shown to account well for observed aggregate dynamics in the post-war United States. We perform policy evaluations based on second-order accurate approximations to conditional and unconditional expected welfare. We require that interest-rate rules be operational, in the sense that they include as arguments only a few readily observable macroeconomic indicators and respect the zero bound on nominal interest rates. We find that the optimal operational monetary policy is a real-interest-rate targeting rule. That is, an interest-rate feedback rule featuring a unit inflation coefficient, a mute response to output, and no interest-rate smoothing. Contrary to existing studies, we find a significant degree of optimal inflation volatility. A key factor driving this result is the assumption of indexation to past inflation. Under indexation to long-run inflation the optimal inflation volatility is close to zero. Finally, we show that initial conditions matter for welfare rankings of policies.

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Citation

Uribe, M and S Schmitt-Grohé (2004), ‘DP4654 Optimal Operational Monetary Policy in the Christiano-Eichenbaum-Evans Model of the US Business Cycle‘, CEPR Discussion Paper No. 4654. CEPR Press, Paris & London. https://cepr.org/publications/dp4654